Are You Missing the Biotech Boat?

Biotechnology stocks are like a cult movie: followed intently by a small group, but generally overlooked by the masses.

Still, a look at the short- and longer-term returns of the biotech sector reveals massive outperformance relative to both the health care sector and the stock market as a whole.

So why haven’t biotech’s returns received more attention?

ETF

TICKER

ONE-YEAR

THREE-YEAR

iShares Nasdaq Biotechnology Index Fund

IBB[1]

47.6%

75.9%

SPDR S&P Biotech ETF

XBI[2]

48.6%

69.4%

First Trust NYSE Arca Biotechnology Index Fund

FBT[3]

30.8%

60.9%

PowerShares Dynamic Biotechnology
& Genome Portfolio

PBE[4]

23.6%

48.2%

Select Sector Health Care SPDR

XLV[5]

23.2%

46.6%

SPDR S&P 500 ETF

SPY[6]

22.6%

44.6%

This table doesn’t even account for the leveraged ETF, ProShares Ultra NASDAQ Biotechnology (NASDAQ:BIB[7]), which has a year-to-date gain of 87% and is the fifth-best performer among all ETFs so far in 2012. Not to mention, the fund’s one- and two-year returns are 107.8% and 159.1%.

Why the big numbers? The industry-specific factors are all positive, with three key trends — an aging population in the developed world[8], broadening Medicare coverage on tap, and the prospect of continued M&A activity[9] — all providing a boost to biotech stocks.

But there’s another factor under the surface that might be the most important of all: Biotech is one of the few areas of the market where investors can reach for beta without also having to take on economic sensitivity. In short, the sector isn’t going to be affected by the next headline out of Europe and China, and that has been a valuable trait in the environment of the past year.

For the average investor who is looking to take a position in biotech, ETFs probably are the best option. Individual biotech stocks are extremely sensitive to the binary outcomes surrounding the drug approval process, whereas the ETFs provide a way to play the positive industry trends without having to take on that added risk.

But as is usually the case, the various funds that focus on the sector take a wide range of approaches. The table below outlines the differences among the five biotech funds, with data sourced from Yahoo! Finance and etfdb.com:

ETF

Holdings

% IN TOP 10

AVG MKT CAP

P/E

EARNINGS GROWTH (TTM)

IBB

117

55.9%

$7.6B

23.0

35.7%

XBI

47

35.1%

$3.0B

23.8

N/A

FBT

20

53.8%

$4.9B

22.2

35.3%

PBE

31

46.8%

$3.2B

19.1

31.2%

BBH

26

65.3%

$12.2B

22.3

28.7%

Is it too late to invest in biotechs?

In the near term, that’s probably the case. Industry giants such as Amgen (NASDAQ:AMGN[11]), Gilead Sciences (NASDAQ:GILD[12]), Biogen Idec (NASDAQ:BIIB[13]) and Alexion Pharmaceuticals (NASDAQ:ALXN[14]) all have valuations that stand at multi-year highs. Also, the simple fact that returns have been so spectacular during the past year argues for an element of caution here. If the market takes a hit for whatever reason, the high-beta sector with huge recent returns is going to be the first on the chopping block. As a result, there’s no reason to chase biotechs right now.

On a longer-term basis, however, the biotech sector looks to be one of the best bets to buy on any pullback in the broader market. The sector offers not just immunity from economic trends, but it also is one of the few that provides investors with the chance to own truly innovative companies. In a slow growth environment, the ability to grow organically through innovation (rather than cost cutting or financial shenanigans) is an attribute that should continue to attract investment capital in the years ahead.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.